Учебный год 22-23 / Critical Company Law

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shareholders require a majority stake in order to ensure the pursuit of their self-interest. Other work has emphasised the importance of law in creating an environment which encourages wide share dispersal. In particular, a body of work from La Porta et al indicates the crucial nature of laws and enforcement procedures which protect minority shareholders:

Company, bankruptcy, and securities laws specifically describe some of the rights of corporate insiders and outside investors. These laws, and the quality of their enforcement by the regulators and the courts, are essential elements of corporate governance and finance. When investor rights such as the voting rights of the shareholders and the reorganization and liquidation rights of the creditors are extensive and well enforced by regulators or courts, investors are willing to finance firms. In contrast, when the legal system does not protect outside investors, corporate governance and external finance do not work well.2

Indeed, La Porta et al claim that legal systems in their entirety will allow or disallow minority shareholder protection. Their research indicates that the historical development of common law systems, originating in post civil war England, was responding to parliamentary attempts to protect private property against the crown. They argue that this emphasis on individual private property has enabled common-law systems to value the protection of the private property interests of minority shareholders. Thus, they maintain, ‘civil law is associated with greater government intervention in economic activity and weaker protection of private property than common law’, leading to ‘inferior protection of the rights of outside investors in civil law countries’.3

In regard to financial markets La Porta et al maintain that systems which protect minorities have more valuable stock markets because when investors are protected from expropriation they will pay more for stock. In their 1997 study they provide evidence that ‘countries that protect shareholders have more valuable stock markets, larger numbers of listed securities per capita, and a higher rate of IPO (initial public o ering) activity than do the unprotected countries’.4 This may also be demonstrated, they argue, by a comparison of two major Eastern European economies in transition. In Poland, they argue, the adoption of strong securities legislation has resulted in the emergence of a thriving capital market. In contrast, the Czech Republic ‘chose neither to introduce tough securities laws nor to create a powerful market regulator at the time of privatization’.5 Now, ‘Czech markets have

2Ibid, p 4.

3Ibid, p 12.

4Ibid, p 15.

5Ibid, p 22.

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been plagued by massive expropriation of minority shareholders’,6 so that ‘in contrast to the Polish market, the Czech market stagnated, with hundreds of companies getting delisted and virtually no public equity financing by firms’.7 According to La Porta et al, one of the attributes of ‘good law’ is rules which can be easily enforced. This often means rules which can be imposed within an existing enforcement structure rather than the construction of perfect rules which cannot be enforced without the further construction of an enforcement agency. A connected issue here is the clarity of the rules in question and the procedures for enforcing those rules. In this respect, the 2006 Act has done much to clarify both the law and the procedures

concerning minority protection.

Contractarianism

Contractarianism in the context of company law maintains that the law should operate to produce the bargain that parties would have come to if they were actually bargaining. By constructing the bargain, therefore, company law reduces the cost of actually bargaining, thus fulfilling the purpose of good company law, which should be to produce the most cost-e cient results

– cost-e cient results being those that produce the greatest return for investors. Accordingly, contractarianism has a tendency to consider minority shareholder protection as not cost-e cient and therefore something which company law could happily abandon.

Exemplifying this position are Easterbrook and Fischel, who maintain that minority shareholder provisions have a tendency to misallocate funds they give power to shareholders who may have a very tiny stake in the business. In respect of the derivative action they state that ‘holders of small stakes have little incentive to consult the e ect of the action on other shareholders, the supposed beneficiaries, who ultimately bear the costs’.8 Indeed, the ‘determining characteristic of the derivative action is the lack of any link between stake and reward – not only on the judge’s part but also on the plainti ’s’.9 Furthermore, they argue, a derivative suit will be to the advantage of other outsiders such as attorneys who will be keen to pursue a case despite its lack of merits and without regard to the interests of the company because it pays them to do so. In contrast, ‘the value of the managers’ time cannot be recouped, no matter how frivolous the action’.10

Accordingly, they argue, the most cost-e cient way to judge the decisions

6Ibid.

7Ibid, pp 22–23.

8Easterbrook and Fischel, The Economic Structure of Corporate Law, first paperback edn, 1996, Cambridge, MA: Harvard University Press, p 101.

9Ibid.

10Ibid.

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of managers is not through the views of minority shareholders or judges, who are poorly equipped to do so, but through the views of managers themselves. A decision that might look ‘hasty’ to the outsider might be the most economically e cient decision for the experienced manager. Corporate law, they maintain, recognises the economic e ciency of limiting minority shareholder actions by such mechanisms as the business judgment rule, which takes most corporate decisions outside of the realm of scrutiny.11 Furthermore, they argue that even the supposedly wrongdoing director is in a more economically e cient position to judge the rightness of his actions than the minority shareholder. They conclude by commending the existing restrictions on derivative actions and tacitly recommending further restrictions. ‘Our discussion of the poor incentives of small shareholders and their attorneys to maximize the value of the firm implies that legal rules should place restrictions on the ability to bring derivative suits.’12

Indeed, it is the many restrictions which exist in respect of minority shareholder protection in England and America which leads Brian Che ns to critique the ‘law matters’ thesis.13 How, he asks, can a rule such as that of Foss v Harbottle (discussed below) create confidence for minority shareholders thus encouraging wide share dispersal? Concurring with the contractarian approach he argues that regulation which ensures an open and free market is a much better mechanism for achieving good governance of corporations. Both America and Britain had poor legal protection for its minority shareholders, ‘instead in both countries other institutions provided investors with su cient confidence to purchase tiny percentages of equity in publicly quoted companies, thus allowing the widely dispersed share ownership that characterizes the Berle–Means corporation to emerge’.14

While case law developed fiduciary duties for directors in principle, the problem for minority shareholders was one of enforceability. The best protection for minorities was market controls, in short a manager’s record for producing dividends. ‘In fact, if not in law, at the moment we are thrown back on the obvious conclusion that a stockholder’s right lies in the expectation of fair dealing rather than in the ability to enforce legal claims.’15 Small investors were induced to invest by the clarity of information produced by the market and its institutions. For example, he noted, the New York Stock Exchange (NYSE) would reject applications to list companies that lacked an adequate

11In that it allows a director to avoid claims resulting form his poor or even negligent decisions on the basis that the decision taken was a business judgment which is assumed in law to have been made honestly.

12Ibid, p 105.

13Che ns, BR, ‘Law as bedrock: The foundations of an economy dominated by widely held public companies.’ (2003) 23 OJLS 1, pp 1–23.

14Ibid p 7.

15Ibid, p 10.

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earnings record or who operated in high-risk businesses such as petroleum and mining. The NYSE ‘saw itself as a guardian of the financial quality of the issuers listed on it’.16 Furthermore, in 1909 it sought to enhance corporate disclosure by imposing ‘a requirement that listed companies distribute annual financial reports to their shareholders and from that point onwards carried out a strong campaign to improve the quantity and quality of disclosure’.17

Likewise, Che ns argues, in the UK, shares only became truly dispersed once the market had taken on measures to protect and inform investors, many aping the controls already adopted in America. Following the Second World War, he states, the London Stock Exchange engaged in much greater quality control, addressing ‘various matters of potential concern to outside investors by strengthening its listing rules. Topics dealt with included disclosure, insider trading and other forms of self dealing by directors and controlling shareholders.’18 Similarly, the Take-over Panel, whose code, originating in the 1950s and largely determines take-over practices, took as its guiding principle the fair and equal treatment of all investors. Che ns concludes that ‘market dynamics, together with privately-orientated regulatory initiatives, did much more than the legal system to enhance the confidence of British investors as the Berle–Means corporation became dominant’.19 And ‘market orientated mechanisms did more to induce investors to own equity in companies characterized by a separation of ownership and control’.20

The reform of the law on minority protection creates a clear statutory regime in which minority shareholders may pursue derivative actions. These reforms reflect the law matters thesis. However, in this reform are contained a number of procedures and checks which halt the pursuit of an action if this action is not in the interests of the company or cost-e cient. These reforms reflect the contractarian thesis.

It is usual for textbooks to discuss other minority shareholder protections, which include statutory protections under s 122(1)(g) of the 1986 Insolvency Act and s 459 Companies Act 1985, in the same chapter or section, and to that extent this chapter conforms to this approach. However, in governance terms these other protections perform quite a di erent role to that of the derivative action. Derivative actions refer to the legal mechanisms which allow a minority shareholder to change the balance of power within the corporation (at least temporarily) on the company’s behalf. On the other hand, statutory protections such as petitions for unfairly prejudicial conduct only apply in quasi-partnership companies and not large companies characterised

16Ibid, p 11.

17Ibid.

18Ibid, p 14.

19Ibid.

20Ibid, p 22.

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by dispersed share ownership. These are remedies which allow informal understandings between members of a company (composed of a very small number of people who act as if in a partnership) to be enforced because their relationships are su ciently close for non-contractual relations to be the modus operandi. These businesses do not fall under the reform project of encouraging ‘enlightened shareholder value’ which applies to the large companies which constitute most of the economy and accordingly, there is little change in this statutory regime.

THE LAW ON MINORITY SHAREHOLDER

PROTECTION

Common-law derivative actions

In the area of minority shareholder protection the law has been dominated by a rule that was established in case of Foss v Harbottle.21 This case concerned a corporation, not a modern registered company. Furthermore, the decision and reasoning were almost certainly intended to apply to the specifics of this case alone and not to have a general application to registered companies, which at the time did not exist. Foss v Harbottle, like the early corporation cases discussed in the previous chapters, was so decided because of the particular terms of this company’s Act of incorporation and despite any general principles in law.

In Foss v Harbottle, two minority shareholders who complained that the company directors had sold their own land to the company at an inflated price were denied redress by the courts. The reason given by the ViceChancellor for this was that although the corporation was the cestui que trust,

the majority of the proprietors at a special general meeting assembled, independently of any general rules of law upon the subject, by the very terms of the incorporation in the present case, has power to bind the whole body, and every individual corporator must be taken to have come into the corporation upon the terms of being so bound.22

The reason the minority had no redress was because the particular terms of the company’s incorporation enabled the company’s decisions to be made by a majority of shareholders at a special general meeting. The company was described as ‘little more than a partnership’, and the judge expressed regret that the shareholders were being deprived of their ‘civil rights’. Thus, one

21(1843) 2 Hare 461, 67 ER 189.

22Ibid, p 195.

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might reasonably expect this judgment to have very limited application. Instead, however, this judgment becomes authority for the proposition that no individual member can sue in respect of any wrong which is ratifiable by ordinary resolution of the members.23 Initially this was constrained by the particular terms of the company’s constitution so that in Mozley v Alston 24 the court articulated the ‘rule in Foss v Harbottle’ to be that an individual shareholder could not bring an action to the courts to complain about an irregularity in the way in which the company’s a airs were being conducted if there was a constitutional facility to ratify the wrong. If there wasn’t, then presumably Foss v Harbottle would not apply.

But, once modern company law had fully articulated what was ratifiable by a simple majority in general law, the notion that ratification automatically put a stop to any legal action by a disgruntled shareholder became the general rule. And, once the company had developed into a distinct economic being and was conceptualised in law as a separate legal being the ‘proper plainti ’ rule was grafted onto the rule in Foss v Harbottle.25 The ‘proper plainti ’ rule states that in respect of a wrong done to a company the proper plainti is the company and not the shareholder. So the rule in Foss v Harbottle is now understood to be that:

•in respect of a wrong done to a company the proper plainti is the company; and

•no individual member can sue in respect of any wrong which is ratifiable by ordinary resolution of the members; and

•actions by individual members can only be done under an exception to the general rule.

Under common-law rules developed in the latter half of the nineteenth century, a member could bring an action against those doing wrong to the company, in their own name, but ultimately on the company’s behalf. In other words, exceptions to the rule in Foss v Harbottle developed. They could take this derivative action if the company was not in a position to protect its own interests because the wrongdoers were in e ective control.26 The wrong in question would need to be a substantial breach of duty and/or a fraud against the company. Thus to bring a derivative action the minority shareholder was obliged to establish both a wrong against the company and that the wrongdoers were in such control of the company as to prevent any legal action by the company.

23Now modified by the Companies Act 2006, examined later in this chapter.

24(1847) 1 Ph 90; 16 LJ Ch 217.

25Neither Foss v Harbottle nor Mozley v Alston articulated the proper plainti rule.

26Atwool v Merryweather [1867] LR 5 Eq 464n; 37 LJ Ch 35.

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Negligence alone has been consistently considered to be an insu cient wrong on which to base a derivative action. In Pavlides v Jenson,27 minority shareholders alleged that the directors were grossly negligent in selling a company asset. The court held that there was no cause of action as there was no fraud alleged, nor had the directors personally benefited from the transaction. However, in Daniels v Daniels,28 a similar gross undervaluation of company assets did constitute an actionable wrong, because in this case the directors had bought the land themselves.29 The court held that under the exceptions to Foss v Harbottle there was no requirement to fulfil the strict criteria of fraud. Such an action could be brought for negligence if such a breach had personally benefited the wrongdoers. As Vinelott J later wryly noted, ‘to put up with foolish directors is one thing; to put up with directors who are so foolish that they make a profit of £115,000 odd at the expense of the company is quite another’.30

Alternatively, majority action which was clearly not in the interests of the company has been su cient grounds upon which to pursue a derivative action. In Estmanco (Kilner House) v GLC,31 the Greater London Council (GLC) formed a company to continue its work of selling long leases on a block of 60 refurbished flats. The company had £3,000 of share capital which was divided into 60 shares valued at £50 which carried one vote. Under its articles of association the company was to allot one share to each new tenant but the votes were to remain vested in the GLC until all the shares were sold. Until that had occurred the GLC remained the sole voter at company meetings. In 1981 the GLC entered into an agreement under seal that included an undertaking that they would use all their e orts to sell the flats on a long lease. Following a change in housing policy the council’s housing committee passed a resolution to the e ect that the remaining 48 unsold flats should be let to ‘high priority applicants on its housing list’.32 The three directors of the company, who were also employees of the GLC but who were fully empowered to act independently in the best interest of the company, sought to enforce the company’s contract with the council. At an extraordinary general meeting a resolution was passed on the votes of the sole shareholder, the GLC, in which the directors were instructed to withdraw all action in respect of the contract. The application to take a derivative action was bought by one of Estmanco’s tenants and the court held that the

27[1956] Ch 565.

28[1978] Ch 406.

29In this case the two directors caused the company to sell the land to one of them and then four years later caused the company to rebuy the land at 28 times the amount the director paid for it.

30Prudential Assurance Co Ltd v Newman Industries Ltd (No 2) [1981] Ch 257, p 315.

31Estmanco (Kilner House) Ltd v Greater London Council [1982] 1 WLR 2.

32Ibid, p 3.

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discontinuation of the action in respect of the contract gave the applicant su cient interest to pursue an action. The wrong was in ignoring the company’s best interests, depriving minority members of the chance to vote and ‘stultifying the purpose for which the company was formed’.33 The court considered the exceptions of ‘fraud on a minority’ to be su ciently wide to cover enforcement of covenants, citing Templeman J’s judgment in Daniels that ‘a minority shareholder who has no other remedy may sue where directors use their powers, intentionally or unintentionally, fraudulently or negligently, in a manner which benefits themselves at the expense of the company.34

Megarry VC stated that the principle stood without the self-dealing aspect in Daniels. The core wrong was misuse of power.

Apart from the benefit to themselves at the company’s expense, the essence of the matter seems to be an abuse or misuse of power. ‘Fraud’ in the phrase ‘fraud on a minority’ seems to be being used as comprising not only fraud at common law but also fraud in the wider equitable sense of that term, as in the equitable concept of a fraud on a power.35

The second arm of the exception to Foss v Harbottle, that of wrongdoers in control, is perhaps more controversial. In Pavlides v Jenson, the action failed both for the absence of fraud, as previously examined, but also because the directors did not technically control the company which was wronged. The directors, however, did make up the majority of the board of the company’s holding company, but, strictly speaking, ‘the shareholders of the shareholding company could in general meeting decide di erently and disagree with the directors of that company’.36 In Pavlides, Danckwerts J required that control be de jure control rather than what it was, de facto control.

In contrast, Vinelott J’s judgment in Prudential Assurance v Newman 37 considered control to be a procedural issue and one that was flexible once fraud had been established. If justice would be thwarted by allowing de jure control to be the only basis upon which to pursue a derivative action then the courts, he stated, should have the flexibility to consider de facto control. In Prudential the wrongdoers in question were two directors on the board of Newman Industries Ltd. First they presented a series of false or confusing documents to the board and then having misled the ‘independent valuer’ presented a misleading circular to Newman’s shareholders. As a result they

33Ibid, p 4.

34Daniels v Daniels [1978] Ch 406, p 414.

35Estmanco (Kilner House) Ltd v Greater London Council [1982] 1 WLR 2, p 12.

36Pavlides v Jenson [1956] Ch 565, p 577.

37Prudential Assurance v Newman Industries Ltd [1980] 2 WLR 339.

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succeeded in persuading a small majority at an extraordinary meeting to pass a resolution approving fraudulent transactions worth £425,000. The directors owned a holding company which owned TBG Ltd, a major shareholder in Newman Ltd, and the recipient of many of Newman’s assets. However, TBG did not vote on the resolution and the directors were not in de jure control of either the board or the shares of Newman. Could a derivative action be maintained notwithstanding that the wrongdoers were not in de jure control?

Citing some early authorities Vinelott J argued that the notions of interests of justice have consistently insisted that issues of control should be flexibly approached to include those in a position to influence as well as those with actual control.

He later referred to Lord Davey in Burland v Earle,38 who stated that the proper plainti rule is a prima facie rule only. To further support this approach, he cited Jenkins LJ in Edwards v Halliwell,39 who stated that ‘the rule is not an inflexible rule and [that it] will be relaxed where necessary in the interests of justice’. On Jessel MR’s pronouncements on the exceptions to Foss v Harbottle,40 Vinelott J surmised that Jessel MR clearly considered that an action could be brought when the company’s interests would be defeated if the minority could not act in circumstances when the wrongdoers were not majority shareholders but were in control. Thus he concluded that the court should be able to assess all the circumstances of a case in order to determine whether the majority is disinterestedly pursuing the best interests of the company.

The ‘justice of the case’ principle upon which Vinelott based his de facto control notion was rejected by the Court of Appeal, which considered the principle too wide and too di cult to apply except when a judge was determining the preliminary issue of whether a shareholder had a right to bring a derivative action at all. Indeed, the court held that the question of whether the rule in Foss v Harbottle applied to any particular set of circumstances should, where possible, be decided as a preliminary issue and not left for determination at the trial. However, the ‘control’ issue is by no means settled in law, and, in the context of large public companies where most shareholders will be governed by a more powerful group, be it directors or a large, visible minority shareholder, it is of arguable wisdom to disregard Vinelott’s ‘de facto control’ test.

Statutory protections

Statute has for many years provided a small number of remedies for minority shareholders whose company’s a airs are conducted in such a manner that

38[1902] AC 83.

39[1950] 2 All ER 1064, p 1067.

40In the case of Russell v Wakefield Waterworks Co LR 20 Eq 474.

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they are being treated unfairly and contrary to any informal understanding they had with those in control of the company, who may be directors or may be the majority shareholder(s). An informal understanding is one that is not held in a contract but is instead an understanding of how the company will be run which has not been put in a legal form because the mutual trust between the parties made such formalities unnecessary.

Section 122(1)(g) of the 1986 Insolvency Act

A minority shareholder may apply to the court to have the company wound up on ‘just and equitable’ grounds under s 122(1)(g) of the 1986 Insolvency Act.41 The factors which the court will consider in reaching this conclusion were amply stated in the well-known case of Ebrahimi v Westbourne Galleries Ltd,42 particularly in the judgments of Lord Wilberforce and Lord Cross of Chelsea. These judgments have a wide-reaching importance providing a basis for interpreting the more widely used remedy under s 459, discussed below and informing the CLR’s thinking on minority protection more generally.

The fact that the inequity of the conduct complained of is a breach of some significant but informal understanding implies that this remedy and indeed a petition under s 459 is usually only applicable in small private companies where the members have had close communications capable of being significant understandings. The members of such companies are likely to have previously undertaken their business under the partnership form, incorporating the business as a company some time into their business relationship. Under such circumstances, it would be expected that the manner in which the business was undertaken as a partnership would continue notwithstanding that the business was now a company to which new formalities and rules applied. Thus much of what the members expected would not be reflected in the company constitution or within the Company Acts but would be contained in mutual understandings of the continuance of partnershiplike relations. In Ebrahimi, Westbourne Galleries Ltd was typical of this type of company, characterised by Lord Wilberforce as a quasi-partnership.

In this case, Mr Ebrahimi and Mr Nizar were partners for a period of 14 years before transferring the business to a private company. They held both shares and managerial positions in such a manner that reflected their previous relationship, that is in equal amounts of shares and equal directorships. Soon after the company’s incorporation, Mr Nizar’s son joined the business as a director and both Mr Ebrahimi and his father gave him 20 per cent of their shares. This meant that Mr Ebrahimi now held a

41Section 122(1)(g) states that the company may be wound up if ‘the court is of the opinion that it is just and equitable that the company should be wound up’.

42Ebrahimi v Westbourne Galleries Ltd [1973] AC 360.